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FRM Part II · FRM Exam Part II · Credit Derivatives

A bank sponsors a CDO of CDOs (CDO-squared) whose collateral consists mainly of mezzanine tranches of other CDOs. Compared with a standard CDO of the same rating, what is the key risk-management concern about this structure?

The main concern is that the collateral mezzanine tranches are thin, highly leveraged to systematic risk and often overlap in underlying names, so losses cluster and results are very sensitive to correlation assumptions. This concentration and amplified model risk make CDO-squared far riskier than apparent diversification suggests.

  1. AIt has lower sensitivity to correlation because of diversification across many CDOs
  2. BIts collateral tranches share common underlying exposures, so losses are highly concentrated and model risk is amplifiedCorrect
  3. CIt removes the need for subordination because the collateral is already tranched
  4. DIt has no exposure to the systematic factor since mezzanine tranches are insulated

Explanation

Mezzanine tranches are thin and leveraged to systematic credit conditions, and different CDOs often hold overlapping names. A systematic downturn can therefore wipe out many underlying mezzanine tranches at once, and ratings are very sensitive to correlation and recovery assumptions, so model risk is large.

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